GLG News by Nicholas Brooke

Implications: Vietnam’s economy has shown one of the strongest growth rates in Asia over the past two years (8.2% in 2006 and 8.5% in 2007) and this level of growth is anticipated to continue into 2008. Strong economic growth together with low labour costs and a young and highly motivated workforce had attracted significant overseas interest and increased investment in both the industrial and real estate sectors. Foreign direct investment in approved projects in 2007 amounted to some US$15-17 billion, a significant increase from the US$10.2 billion secured in 2006. Membership of the WTO, which was achieved in January of 2007, has encouraged further large scale investment interest, particularly as privatisation of State Owned Enterprises is expected to be completed by 2010. This should encourage joint ventures and foreign investment in previously non-accessible sectors.

Analysis: A precursor to WTO membership was the announcement of both the Common Investment Law and the Unified Enterprises Law in July 2006 which introduced a common legal framework for all types of enterprise and provided for equal treatment of all investors. Some 70% of Vietnam’s population of approximately 84 million is below 35 years of age, there are minimal ethnic, religious or political divisions and there is a palpable energy to be felt in the major centers which is reminiscent of Hong Kong and Mainland China in the early days of their economic expansion. Over 106,000 SME’s have mushroomed in recent years, with many families involved in small retail businesses, and this entrepreneurial spirit is also very apparent in the real estate sector.

Improving legal infrastructure
Prior to 1990 all land in Vietnam was owned by the State and there was virtually no real estate market as there were no laws to regulate the use and transfer of property in the private sector with housing being distributed by the State. However in 1986, the Government introduced the “doi moi” reforms which led to a slow movement towards a more open and market driven economy. The first land laws came into force between 1990 and 1998 when the concept of private “ownership” was recognized. Widespread speculation resulted and land prices soared, with a number of foreign investors undertaking large scale commercial and luxury residential projects on both Hanoi and Ho Chi Minh City. Between 1998 and 2004 revised land laws were decreed to curb speculation and with the onset of the Asian financial crisis many foreign invested projects collapsed, although the Vietnam economy itself did not suffer too severely. Small local developers emerged but no major projects were undertaken as there was little or no interest from overseas. In 2004 the new Land Law attracted increased foreign interest and enhanced real estate funding options. These, together with new and continuing reforms in the regulatory and legal structures, the improved economic conditions, increasing incomes and shortage of supply in all sectors, encouraged new foreign investment.

New land tenure measures

At present only Vietnamese nationals can own land or houses, only being able to rent land and build houses to sell or lease although “sales” of 50 year leases have been quite common for some years. However, it is understood that further reforms could also be on the way with the Ministry of Construction drawing up plans for an experimental project to permit foreigners to buy houses and own land in Vietnam for a maximum period of 70 years subject to legal conditions being met. Land use rights now have to be auctioned when the State sells or leases land, improvements have developed in mortgage lending with 75% loans over 15 years now available, joint venture developers are permitted to build apartments for sale and compensation for losses due to redevelopment are now closer to market values meaning the site clearance is no longer such a long drawn out issue. All land continues to be held by the State with land use rights (LUR) being sold in very much the same way they are in China. Vietnamese citizens can have effective “freehold ownership” in that there is no time limit on their LUR of residential land and can joint venture with foreign investors with the latter also being able to lease directly from the State for development purposes. LUR owned by foreign companies are granted for 70 years in special cases such as projects with large capital requirements or those located in under-developed socio-economic areas and limited to 50 years for other uses. Such periods will be renewable for further similar terms subject to the investor meeting the conditions that there is a need to continue using the land, the project is fully compliant with the regulations regarding land use and such continuation of land use is in accordance with the government’s master planning. LUR can be leased, mortgaged, exchanged, transferred or inherited although large scale projects still require the approval of the Prime Minister.

What is driving the new strong demand for real estate in Vietnam?

• Increased standard of living and rapid urbanization
• Current lack of supply
• Urban infrastructure development
• Increased availability of mortgages
• Growing remittances from over 3 million overseas Vietnamese
• Large young population looking to buy their own homes
• Developing real estate legal framework
• Strong growth in tourism

What are the major opportunities?

Strong residential demand from newly weds
The residential sector is very attractive as there is significant latent demand driven by the rising income of the burgeoning middle class. In 2006 the GDP per capita in PPP terms across Vietnam was some US$3,100 while in actual terms the level reached US$820. Actual per capita GDP in Ho Chi Minh City, the commercial centre of the country, rose to US$1,970. The young profile of the population means that many are at an age when they wish to marry and have their own home and it is estimated that there is a need for 60 million square meters of urban residential space – almost doubling the current stock. With prices ranging from US$900 per square meter upwards in the mass market and US$1,200 upwards in the luxury sector, there is still no shortage of purchasers.

Limited quality office accommodation available

The office market also offers opportunities in that there is a serious lack of quality accommodation in both Hanoi and Ho Chi Minh City, with both having occupancy rates of 95%. It is only recently that new project of over 10,000 square meters have commenced and the continuously rising rental have now reached the same levels as those seen in Shanghai (i.e. between US$40-50 psm pm exclusive of VAT). Some 540,000 square meters of new office space is required in HCMC by 2010 with the figure for Hanoi estimated at 150,000 square meters, assuming current growth in new businesses continues. Few real shopping centers as yet A nascent market for modern retail formats is now starting to emerge and the amount of retail space will need to expand by 5 times over the next 5 years to match stock to population ratios in other Asian cities. There is no real shopping centre in HCMC and only two department stores so that while some projects are under development the market is still wide open. The leisure and hotel markets are other areas of interest with Vietnam billed at the next Thailand – its 3,000 km of coastline is very suitable for resort and villa developments and tourist arrivals have increased 25% since 2004. Four and five star hotels are enjoying very high occupancy rates during peak periods and there are many opportunities for foreign operators to improve service and returns.

Demand for new urban centers

In the industrial sector, many of the industrial zones, particularly those close to HCMC, have limited supply of ready built factories available due to recent demand and international newcomers mostly have to build their own facilities so that new industrial parks could prove to be sound investments. There is also mileage in developing new townships and communities in areas surrounding existing urban areas in that “green field” development can be more straightforward and subject to fewer delays in the approval process.

Where do the challenges lie?

Vietnam is an emerging market and transparency is not yet all it might be. Politics still play a role in economic decisions and delays can arise for reasons which are difficult to understand. However, the new laws and their implementing regulations are improving matters and while projects may progress more slowly, if they are properly structured and funded and designed within the known planning parameters, they should eventually receive the licenses and permits required. In many cases it is an advantage to have a local partner who can assist with relocation issues and steer the project through the various statutory and licensing processes and that choice of partner is, as in any emerging market, critical. Similarly, time and effort spent on diligence, or parting the curtains, and not necessarily accepting everything at face value, is time well spent. Imperfect the market may be but there is a clear correlation between risk and reward and the ability of the economy to leapfrog many traditional stages of development means that it is already asserting itself as a significant player in the region and attracting investment accordingly.

Implications: I am sure you do not need me to tell you of the growing significance of the commercial real estate industry in the Asia Pacific region, both from a development and investment perspective, and the part that both local and international designers and advisers are playing in bringing a greater level of order, professionalism and sophistication to the market place. I could spend the time writing about the weight of capital chasing real estate, the deals that have been done, supply/demand statistics and the health of the various markets. However, I thought I would take the opportunity just to share one or two thoughts with you about some of the pluses and minuses as I see them going forward.

Analysis: We have in reality in Asia Pacific a real estate sector in major transition brought about not only by the amount of liquidity chasing limited opportunities but also by the arrival in significant numbers of the institutions and large funds who traditionally have been risk averse but whose investors and shareholders will no longer allow the fund managers to put Asia Pacific into the too difficult tray. The arrival of the institutions, coinciding with the evolution of a REIT infrastructure is, bringing with it the rigour, the requirement for transparency and the flight to quality that all of us as property professionals believe to be fundamental if a market is to function effectively and efficiently.
At the same time, of course, it puts us all under the microscope to deliver but I am sure that the professions can and will respond to the challenge and step up to the plate. Clearly, there is going to be greater need for due diligence, for valuation skills, for master planning, creative design and engineering solutions, for project delivery services and for marketing, and facilities and asset management and I am sure that I have missed a number of added value services along the way. However, we can be sure that the new round of institutional investors will expect services delivered to an international standard and best practice to be applied throughout.
One interesting phenomenon that I can already see emerging is the change in the pattern of ownership of real estate with, over time, the institutions and the funds becoming the major owners of commercial property across the region and the emergence of a more mature market model where the developer is in effect “a delivery agent” and is able to exit by selling on to an institution rather than by strata title sub-sales.
The institutions, of course, will bring with them a culture of enhanced asset and property management and over time I believe we will see the emergence of benchmarking and the production of industry accepted Indexes and in time the regular trading of derivatives based on such Indexes.
All this is positive and bodes well for the future. Where therefore do I see the challenges going forward? Firstly, I have to say it concerns me when I see institutions taking development risk. Granted in today’s market, with limited choice, many have no option, if they are to make headway and to meet investors/shareholders aspirations, than to buy into semi-completed schemes. I accept that in such cases the acquisition, compensation and land use planning risks have been eliminated but there is still construction risk – risk to complete as it might better be described – and in many cases also market risk. Institutions are in my experience not best equipped to deal with such situations and are very dependent on their local partner and advisers. Also, with the pressure to invest, we are seeing institutions buying into projects at an earlier and earlier stage and this increases the potential for something to go wrong.
Secondly, there is the issue of project delivery and be you developer, institution or advisor all of us are facing the challenge of resourcing and finding suitable talent. There simply is not enough talent to go round, particularly as much of project delivery requires input at a senior level. Over time, I am sure the market will respond through training, transfers of knowledge and the introduction of even more sophisticated planning and monitoring systems, but short term it is a quandary. What I do see happening, however, is a move to the formation of strategic alliances where large developers and investors form alliances and even just ventures with key service providers and even contractors and material suppliers to ensure access to a dedicated team/set of resources in return for a dedicated work flow. Positive in one sense, but difficult for those who are either spread geographically or who cannot offer continuity of projects.
Finally and I think this is my biggest concern. It is all about what I call the rationalization factor and to my mind, this is always the signal that prices or rents have outpaced market fundamentals. It is where your buyer, be he/she fund manager, investor or end-user, rationalizes what previously were challenges and even difficulties and now describes them as opportunities. Not long ago, a half empty building was seen negatively and the value marked down accordingly but now it is presented as an opportunity to secure an open market rent. Similarly, weakness in tenant mix or in covenant strength is now portrayed as an opportunity to improve matters in the future and any form of uncertainty, far from being an issue, is seen as a value play. Granted it may be if you finesse the situation successfully, but there always two sides and two potential outcomes to any argument of this nature and when the market begins to rationalise or worse still chooses to ignore risk, I sense, certainly as property professionals, we ought to be stepping back and putting up the appropriate markers.

Implications: What is not necessarily appreciated by those both within the property sector and without is that we are in effect an industry in transition and that recognising and responding to the challenges and opportunities that this presents will differentiate the future market leaders from the rest of the pack.

Analysis: First and foremost we are seeing significant shifts in the dynamics of the market place involving a greater degree of diversification of both geography and product than we have ever seen before. Secondly, we are seeing the financial institutions, many of which regarded the emerging Asian markets as too opaque, risky and difficult, beginning to stamp their authority on the market place.

Who, for instance, would have anticipated that the Hong Kong developers would have largely turned their backs on Hong Kong, except for the luxury residential sector and prime sites in the urban areas? To be fair, they have, they have some excuse in that 15,000 residential units a year, which is where demand and supply currently sit fairly comfortably, is unlikely to keep them fully occupied. Who would have predicted that over a matter of months the Hong Kong developers have amassed land banks and development rights in the Mainland in excess of those that they own here in Hong Kong. A lot of the sites have been purchased in the open market, at auction or tender, and therefore the land price is fairly full but clearly they see greater potential upside in the Mainland than they do in applying for sites to be released from the Application List in Hong Kong - as strong reason as any I would have thought for expanding the number and range of sites available through that process.

The arrival of the financial institutions is also interesting, driven again by pressure to diversify, to be in Asia and to secure improved returns, but more particularly by the increased allocation of investment funds to real estate, linked to the recognition of the inherent qualities of real estate as an asset class. Many insurance companies, pension funds and similar institutions have significantly increased their allocation to real estate and this has led to yield compression and increases in capital values across most markets to the extent that many ask whether, for instance, office rental returns of 2-3% are sustainable. The answer, of course, is that it depends on the amount of growth in capital values that is anticipated will take place over the similar period but the reality is that growth in capital values is closely correlated to the anticipated growth in rental values and you will need to see continued steady growth in the latter if overall returns to investors are to be sustained at double digit levels as in the past.

The most challenging aspect of the huge weight of money trying to find a home in real estate, particularly in Mainland China, is that it is forcing hitherto conservative institutions to take development risk. Ideally, financial institutions like to purchase completed developments with a settled rental income stream but now, because of the competition for investment grade product, they are having to buy into projects long before completion of construction and leasing. Initially the institutions sought projects which were at most 18 months or so from completion which limited their exposure to construction and market risk. However, more recently, because such projects are not always easy to secure, the institutions are buying in even earlier and as a result exposing themselves to the whole gambit of risks associated with property development. This is something to which they are not accustomed and for which, quite frankly, many are not equipped.

The challenge for them is now one being faced across the region, namely how effectively to achieve delivery of these projects and it is, of course, a major new opportunity for those with development experience. It will be interesting to see who stands up to be counted and sets out their stall as the project deliverer of choice in Asia.

Another more subtle change that is occurring is in the ownership pattern of real estate. In the more mature markets of the world, the majority of prime real estate in owned by financial institutions and developers effectively act as “delivery agents” and develop with a guaranteed exit route and price for the completed project. Hitherto in Asia such exit opportunities have not existed and the developers have been left to strata title or to hold. Now there is a clear exit route available and over a relatively short period of time I believe we will see the institutions owning most of the prime buildings in our major cities, which will free up a large amount of the capital that developers currently have tied up in finished buildings. This in turn will put pressure on the developers to make better use of the capital resources at their disposal and not just to sit and let the market do their work for them.

With the greater presence of the institutions will come pressure for greater transparency and a more open dissemination of information together with production of reliable and independent indices which accurately track market performance. All this is positive to those who look for an efficient and effective market place but there are those, of course, who prefer markets that are imperfect and opaque and the opportunity to exploit these weaknesses, but that is a story for another day.

Implications: What we are seeing is neither a boom nor a bubble – but rather a series of markets in transition. These are all being impacted by and responding, to a greater or lesser extent, to the same influences, be it weight of capital, repositioning of property as an asset class, the introduction of new real estate investment structures, rising community aspirations or the ever increasing attention being paid to Asia by financial institutions, multi-national corporations and investors in general. Whether it be boom, bubble or indeed bust will depend on the extent to which markets recognise and react to these influences and the level to which and the pace at which the markets can accommodate the changes they bring.

Analysis:

According to a recent report by DTZ, the current total value of real estate stock in Asia amounts to some US$9.5 trillion of which some 50% is located in China, just under 20% in Japan and 12% in India. With the exception of China, where stock is growing at close to 15% per annum, growth across the region is more modest averaging 6-7% per year. By contrast institutional investment about which we hear so much, whilst doubling since 1997 still amounted only to some US$200 billion in 2006. Similarly in 2006, the amount of overseas investment in the Asia property markets only amounted to some US$50 billion compared with a global transactional total of almost US$700 billion. It is still therefore largely a local game.

Whilst the quantum of institutional investment in the overall context therefore does not yet appear to be of overwhelming significance, there is no doubt that the institutions are playing, and will play, a major role in shaping the future of the marketplace here in Asia, driven by a combination of factors including the wish for:

• Diversification of property holdings
• Superior returns
• An expanded portfolio
• Access to a wider range of real estate stock
• Diversification from other asset classes
• Response to investor/Board expectations

Their concerns centre primarily around the liquidity of the real estate investment markets, availability of information, the size and maturing of the local property markets as well as land tenure, taxation and currency risk amongst others.

Traditionally the institutional preference has been for completed product with an established income stream but over the last two or three years, due to the dearth of product of appropriate investment quality, institutions, and indeed investors at large, have been forced to buy into projects during the development phase. Initially, the target was to buy into projects nearing completion and thus only assume construction and marketing risk. However, more latterly, because of the competition, investors have been becoming involved as a much earlier stage in the development process and as a result are assuming land conversion and land use planning risk as well as those risks associated with construction, marketing, etc.

Obviously this presents the opportunity for these particular investors to stamp their authority on the project in terms of mix, design and construction standards but it is an area in which many institutions have not had previous direct experience and exposes them to a far wider risk spectrum than hitherto. One argument put forward is that early entry to development projects affords the opportunity to secure higher returns but does 10-12% IRR for a commercial development in Beijing or Shanghai with entry at the outset of the project really fully reflect all the risks?

In terms of regional trends, the story of the past five years, particularly in the commercial sector, has been one of rental growth with annual rental growth across the Asia averaging over 8%. Shanghai, Bangkok and Hong Kong have significantly exceeded this average and many other cities were not far below with only Taipei in negative territory. If we look forward to the next five years, however, this level is unlikely to be sustained with average rental growth predicted to fall to 5% per annum. Only Singapore and Tokyo are expected to exceed this level and many cities will see much more modest growth over the period. The reality therefore is that in order to maintain overall growth rates capital values will have to increase to compensate and the question must be, will this occur? My sense is that we will continue to see rises in capital values notwithstanding the reductions in rental growth partly because of the weight of money seeking to acquire real estate is likely to increase and partly because institutions will further adjust to the risks of investing in real estate in Asia and accept lower overall returns.

Interestingly I see one of the key challenges going forward being project delivery, a topic which surfaces at every Board on which I sit. With markets not just in Asia but in many other jurisdictions moving forward at a pace, the sourcing of human talent with experience of delivering large projects is a real issue and indeed, if not a direct constraint, could potentially impact on many projects in terms of delay and cost over-runs. As a consequence I foresee the creation of many strategic alliances with contractors and service providers where investors and developers alike will seek to secure the allocation of dedicated resources and a professional capability by guaranteeing a certain stream of work. Indeed, for those who aspire to be the project deliverer of choice across the region and are willing to provide what is in effect a turn-key service, I believe they have a bright and remunerative future.

Enough then on the influence of the institutions and on to a brief overview of the factors influencing supply and demand in the commercial and residential markets around the region.

Property markets in Asia have a reputation for being notoriously fickle and volatile. Others more knowledgeable than I will no doubt comment on whether the sub-prime turmoil of the past few weeks represents a freakish credit bubble which, whilst slowing the US economy is not likely to have other than a passing impact on the economies and the property markets in the region. Some predict greater pain for South Korea and Taiwan but the consensus view appears to be, worst case, that it might remove about 1% off an Asian GDP forecast to average 7-8% over the next several years. In reality, I believe that inflation is possibly the biggest challenge facing Asia this year and the consequence is that with inflation still untamed and liquidity still reasonably easy to access, there is little scope for interest rates to fall.

Dealing firstly with the commercial sector, I have already commented on the inadequate supply of investment grade product and the impact this is having on the risk profile of the institutions in Asia and on the skylines in several of our major cities. An interesting debate is growing as to the role of the Central Business District and the likelihood of bi- or even tri-nodal CBD’s emerging in what are in effect the large city regions which are now becoming common across Asia. In this context I am thinking of Hong Kong, Beijing, Shanghai, Mumbai, Seoul, Jakarta and Tokyo where urban planning and transport constraints mean that a single CBD is neither practical nor appropriate. Whilst this removes some of the historic and yield exclusivity, it widens the options from an investor perspective.

Yield compression and aggressive capital values are also something which has been aired widely at the conference already and whilst I believe, given the repositioning that has taken place in relation to real estate as an asset class, that the lower yields and higher values are largely now a fact of life, we have undoubtedly seen some froth and exuberance in the pricing of recent transactions. In this regard I do become concerned with what I would describe as the “rationalisation” factor, when what was previously regarded as a constraint which would have been be reflected in the pricing, for instance a half empty building, is now considered or argued to be an opportunity – in this case to secure a market rent and the pricing is skewed accordingly. This is when we move from boom to bubble.

In terms of the residential markets around the region, a lot of the media attention has been focused on record breaking prices in the luxury sector and the doubling, if not trebling, of values in Singapore. Whilst people generally across the region are better off and there are aspirations for improved housing quality, affordability is again emerging as an issue as the gap between have’s and have not’s widens in a number of markets. It was worrying enough when mortgages represented five or even ten time family income but a multiplier of up to 20 times is now not unusual. More particularly this has focused attention again on the provision of social housing and the role of Government in this sector. We have seen the Chinese Government attempting both to influence the size of units and to launch land sales where the units to be built are to a predetermined size and sales price and given the emotion that understandably surrounds the issue of home ownership, the possibility of further intervention, in particular in the residential sector cannot be ignored.

Another factor which is going to shape the future of the residential markets around the region is the changing demographic patterns in terms of aging, lower birth rates, population policies and urban migration. Nowhere is this more evident than in Hong Kong where we are seeing a hollowing out of the population and negative growth if inbound migration is excluded. The net result is that our housing production has declined to about 15,000 units per annum and our traditional residential developers have turned their attention to Mainland China.

With the emergence of a more educated and market savvy purchasing public, demands for mixed use, sustainable communities, rather than single category estates, are gaining ground and there is a growing focus on lifestyle and convenience. There is and will continue to be debate about sustainable development, urban planning and the shape and form of our cities.

It is perhaps worth spending a few moments considering the issue of sustainable development to which many have paid lip service to date but which undoubtedly is going to be a factor in the successful future growth and development of cities in the region. Indeed it is increasingly likely to become a factor which influences investor and occupier choices and the way in which cities respond and react to this challenge will very much determine how they are rated in terms of the regional pecking order.

All the major cities around Asia are struggling to devise an acceptable model for the revitalisation and rejuvenation of ageing city centres and suburbs that strikes the requisite balance between renewal as against redevelopment, maintaining as against dispersing established communities, low versus high densities and social and economic priorities. Just as we have found in Hong Kong, communities around the region are seeking to be engaged at the planning stage of projects rather than consulted on pre-determined options and whilst this lengthens the lead period it is something that the authorities are learning to accept rather then face objections during the implementation process.

More cities are approaching their urban planning on a comprehensive, city-wide basis rather than site by site. Even in China and Vietnam, Asia’s latest real estate investment destination, wholesale demolition and clearance of older properties can only be achieved after negotiation with local residents and business operators and the payment of compensation that at least enables purchase of alternative accommodation, albeit not in the same location. Finally, there is generally less and less focus being given to the “hardware” and more importance is being attached to the underlying software, such as diversity, education, employment opportunities and quality of life as an increasing number of cities in Asia aspire to be regional centres, if not ranked worldwide.

What then are the immediate issues to be reckoned with?

Unfortunately one of the prices that is to be paid for what many Governments see as the potentiality for “bust” is increased Government intervention, particularly, but not restricted to, the residential sector. In most markets around the region land is vested in the state and seen to belong to the community – hence the leasehold/land use right nature of tenure. Traditionally there has been and still is a strong emotional attachment to land and in many countries it is still a major contributor to the national economy. The supply of new land is essentially controlled by the state and the release of that land is likely to be policed more closely in the future. We have seen the move to auction and tender in China and the impact that has had on land values and more recently Vietnam has announced a move to an open sale approach. The risk with Government involvement, as we have learnt in Hong Kong, is that in trying to second guess the market, Government frequently either gets the timing wrong or under or over reacts. Similarly the ability of Government to influence and even decide bank lending policies and to misunderstand the motivation of foreign investors is going to be an ongoing factor during this transitional stage.

Furthermore, regionally we have not really moved, although some claim that we have, from a trading to an investor mentality so far as the local players are concerned and many still regard real estate as a commodity which is to be bought and sold simply as a means of creating wealth. We should not anticipate therefore the demise of the speculator or trader who will continue to influence the scale of the upward and downward swings in the market.

With the increasing investment by institutions in Asia, there is also the need to develop enhanced asset management skills, particularly as they impact on real estate and the whole way that we manage and administer property portfolios. One of the positive aspects of the advent in greater numbers of the institutions, is that they bring with them the demand for transparency, greater accountability and a much a more pro-active and professional approach to real estate investment. Similarly I am sure we will see the development of new investment products, the creation of reliable indices and the use of derivatives as a hedging mechanism, all of which will drive the requirement for more open and sophisticated management skills.

What therefore of the medium and longer term future?

Whilst in theory investment flows know no boundaries and there will continue to be boardroom and investor pressure to invest in Asia, I believe concerns over the rapid rise in capital values, affordability concerns and the sensitivity over real estate will result in increased intervention by Governments at least in the medium term. Whether action is taken to restrict land supply, lean on the banks, impose taxes or just generally slow down the process, unfortunately foreign investment is still perceived by many as a threat as well as a benefit. In this regard I believe there is the need for a major two way education initiative to ensure that both investors and potential recipients alike understand both the advantages and the sensitivities involved.

Longer term I believe that we will see the institutions assuming a greater and greater role in the marketplace and just as in other major mature property markets of the world they will become the principal holders of completed real estate and bring with them the discipline to which I have previously referred. The developers for their part, in the case of investment property, will largely become “pre-order” or “build to suit” delivery agents with a pre-agreed and pre-determined exit route. Unfortunately, given this scenario, I see the opportunities for extra-ordinary gains being the exception as the market matures and becomes more measured.

In conclusion, boom – certainly in a number of cases, bubble – a risk in some sectors - and a major transition for sure, the effects of which should not be underestimated.

Implications: Given that the Hong Kong property market, in particular the residential sector, is regarded as one of the key measures, if not the barometer of the economic health of the city region, it is not surprising that “what state the market” inevitably surfaces, be it during a chat over a coffee in Starbucks, a discussion over dinner amongst friends or a debate around a boardroom table on a new strategic initiative here in Hong Kong.

Analysis:

Given the current buoyancy of the market, we tend to forget the major corrections in 1997/98 that followed the Asian financial crisis with residential values falling by as much as 70% in some cases and commercial values up to 50% with the consequence that several hundred thousand households moved, virtually overnight, from a world of asset appreciated to negative equity. Similarly the 54 months of deflation that followed, compounded by the impact of SARS, all now seem to be a dim memory but they all remain a useful reality check reflecting the interdependence of Hong Kong with the regional and world economy and a reminder that property markets are by their nature cyclical and what goes up can also come down!

However, fortunately Hong Kong was not to be held down and bounced back and the recovery that has occurred over the last two and a half years is a reflection of the strengths of Hong Kong – the underlying resilience of the economy, its ability to adjust to changing circumstances and the strength of the offer – be it transparency, the rule of law, the ease of doing business and the absence of any restrictive barriers to entrepreneurship.

As a result, we saw in 2006 a continuation of the upward movement in prices and rents that was characteristic of the market in 2005. Much of the focus centered on the office sector where, because of limited supply, rents in Central again topped the HK$100 per square foot (psf) mark, having been as low as HK$30 psf only two and half years earlier. Similarly, as a result of strong institutional interest and, some would say, excessive liquidity, we saw office initial yields falling to as low as 3% and office buildings being injected into REITs at even lesser multiples, which in turn raised questions as to sustainability of such levels in the longer term. When potential investors rationalize what were previously “difficulties and constraints” and re-brand these as “opportunities”, then it is probably time to step back and take a view!

On the residential front, the story in 2006 was largely about the luxury residential market with Hong Kong setting a world record when a parcel of land on the Peak was sold by auction for HK$42,196 psf. However, there were other examples of serious interest in this segment of the market with a site in Kowloon Tong also setting new levels of value. This focus can, of course, be directly attributed to the renewed interest of regional investors, large bonuses paid by most finance houses, cashing in on Stock Market gains and the part now being played by an ever growing group of Mainland entrepreneurs, many of whom have become millionaires as a result of taking their companies public in Hong Kong.

The mass market, however, attracted less attention and any gains were modest, if at all in some cases. This, of course, is a reflection of the changing demographics of Hong Kong where our population growth has slowed dramatically and may even, in fact, be in negative territory and where we are now reliant largely on newly weds and upgraders to drive this part of the market. Production has fallen significantly to some 15,000 units per year from a historic average of 35,000 units per annum and it is in my view likely to stay at these lower levels unless there is a significant change in Government’s immigration/population policy. It is not surprising, therefore, that the major developers are now looking north for the majority of their development projects as there is just not enough to sustain them here in Hong Kong.

On the retail front, we again saw significant uplift in rents, largely driven by our visitors from the Mainland and overseas, but this was tempered by some resistance from tenants, particularly those operating in the food and beverage arena who claimed that rents levels were no longer affordable and many landlords adopted a pragmatic approach so as to maintain their tenant mix. Many hotels also had a record year both in terms of room rate and occupancy with “no room at the inn” signs on the door during the key months of October and November and indications are that we may face an even tighter supply situation for the foreseeable future with the loss of the Hyatt Hotel in Kowloon and the likely demise of the Ritz Carlton in Central.

Enough, however, of the past. What does 2007 hold, how will Hong Kong continue to justify its premium in comparison with its competitors in the region and on a balanced score card basis what are the strengths on which we should capitalize and where are the weaknesses that we hope the new Chief Executive will seek to address over the five year period of his tenure?

In terms of projections, whilst the demand for office space will remain strong in Central and rents will reflect this, I believe we are now beginning to see some serious resistance to rental levels in other locations. As a result there will be some easing in decentralized districts as well as increased focus on KowloonBay and in due course on the ICC above the Kowloon MTRC station and Airport Interchange at Union Square. This, I believe, to be important in the context of Hong Kong’s competitiveness because, based on recent surveys, only London heads Hong Kong when a meaningful comparison of occupational costs is undertaken and we well exceed both Shanghai and Singapore and now even Tokyo. On the residential front, whilst the mass market is likely to remain quiet, I see continued interest in the luxury sector with growth in values of up to 20%. Retails rents and prices are pretty full now as well, so that whilst there will be quite a lot of movement and activity, I envisage it will take place at current rental and price levels.

All this bodes well, of course, if you look at Hong Kong in the round and we do have distinct advantages over cities such as Shanghai and Singapore, not least that of location and the ever growing economic and infrastructural interface with the PRD and Southern China. Inclusion of Hong Kong and Macau in the 11^th 5 Year Plan by the Mainland authorities and recognition of the need to maintain the international brand, I believe, are positive in terms of our strategic direction. There are also many other attributes, some of which I have mentioned earlier, that warrant the premium that Hong Kong attracts both in terms of capital values and rents.

However, there are clearly issues and challenges that need to be addressed if we are to maintain our status as a premier international city. Not least is the issue of air quality but I would suggest that the challenge goes much further than that and centers on the how we plan and manage our city in the future. A land disposal system which is driven by highest and best use; a planning system which seeks to support that income generating regime rather than adopt a holistic and sustainable approach based on community and lifestyle considerations; and policies which still rely on the development community to fund and undertake cultural, heritage and urban regeneration initiatives, all require a fresh look. Whilst they possibly could have been justified on the grounds of expediency at a stage when Hong Kong was in growth mode in the 1980’s and 1990’s, and many of the population were in “transit mode”, there is the need to adopt a new mindset and approach to match the growing aspirations of a community that now seeks to have a say in the future of the city. Not that these need be permanent impediments to the quality of the offer but the long term sustainability of the property market and values and rents is inextricably linked to the quality of the living and working environment.

It is encouraging to see many of these issues being flushed out during the current CE election debates but the key to enhancing the quality of Hong Kong’s offer will be way the new Chief Executive, through listening and engagement, develops innovative policies and solutions which have the support of the majority and then is prepared to champion those initiatives and move them forward.

At the moment, I think it is possible to argue that the premium is justifiable but it could potentially be whittled away unless we are proactively seen to address the challenges surrounding the sustainability of that offer which require a brave approach to difficult decisions.

Implications: When one hears today of significant short term capital gains being made through trading at the top end of the residential market, one might be forgiven for thinking that not much has changed since the heady days immediately prior to the handover in 1997. In practice, however, the situation is very different in that it is only within this relatively small segment of the market that such speculative opportunities have arisen, and then only over the last two years. By contrast, in 1997, speculation could be found in all sectors and a “pass the parcel and hope that the music does not stop” mentality prevailed and contracts could be flipped within a matter of days. Even today, the short term investor is likely faced with 6-12 months of ownership before being able to take his profit.

Analysis:

The reality, of course, is that it was all too heady and the music had to stop, which it did very suddenly and hundreds of thousands of families found themselves in negative equity. Today, certainly in the case of the mass residential market, we have a purchaser who deliberates longer, who is influenced by affordability, who is discerning in terms of locality, finishes, management, facilities, etc. and who envisages living in the premises for a period of years – in essence, someone who treats the purchase as an investment whereas ten years ago property was largely regarded as a commodity to be traded at the earliest opportunity.

The other significant difference, which is an extension of the new investment mentality, is the flight to quality and lifestyle. This, of course, is partly attributable to the economic recovery which has taken place over the last three and half years but more particularly to a growing interest in the environment and quality of life. Who, for instance, would have thought in 1997 of senior executives buying multi-million dollar houses in the NewTerritories and commuting to work for the sake and benefit of their families?

We have seen a similar transformation in the commercial sector where the recovery of the economy has resulted in increased end user demand, be it by owner occupiers or tenants, and this in turn has been translated into record rental growth, particularly in the major business districts. We have also seen the advent of the institutional investor and increased allocation of investment funds not only to real estate but also to Asia. This appetite has led to significant yield compression and consequent increases in capital values, such that, in reality, any latent margin for the trader has been eroded. This contrasts with ten years ago when, notwithstanding that the returns were considerably higher, the market was regarded by the institutions as far too frothy. It is interesting to see how those who in 1997 would have discounted heavily for a half empty building now rationalize the situation and contend that what previously was a problem is now an opportunity to secure market rent.

Another significant change is, of course, the acceptance by Government that it should not be in the business of providing housing except for those who cannot adequately help themselves and that the private sector is better equipped to respond to market demand at all levels. This is also reflected in Government’s acceptance that it should not try to second guess the market by designating the number of sites to be sold at auction or tender each year but rather, by introducing the Application List System, it would allow the market to decide, although reserving the right not to release sites unless underwritten by a bid close to market value. The other interesting change is one which is largely a function of demographics in that ten years ago we were talking about producing 85,000 residential units a year while today Government is now telling us that 15,000 units per annum is sufficient to meet current and future demand.

The other major difference is the development environment where many things prior to 1997 were rationalized on the grounds of growth and that Government knew what was best for Hong Kong. As we have seen recently that model is no longer sustainable and we have a community that not only wants to be involved but also has strong views on densities, building heights, roads, air circulation, sustainability, heritage, etc. This, of course, makes the development process more complex and time consuming but it is a natural reflection of a maturing market where ownership and belonging, in all senses, are increasingly important.

And finally, a cautionary tale. If you were to have left your money on the stock market you could be 43% (the overall increase in the Hang Seng Index for the period) better off today than in 1997, which is a salutary lesson for those who placed their faith in real estate and bought then and are just now beginning to see a little daylight!

Implications: Vietnam’s economy has shown one of the strongest growth rates in Asia over the past two years (8.4% in 2005 and 8.2% in 2006) and this looks set to be repeated in 2007. This level of growth together with low labour costs and a young and highly motivated workforce had attracted significant overseas interest and increased investment in both the industrial and real estate sectors.

Analysis:

Foreign direct investment in approved projects in 2006 was some US$7.66 billion, including US$1 billion by Intel, while a further US$5 billion of proposed investment was under consideration by the authorities. Membership of the WTO, which was achieved in January of this year, is likely to encourage further large scale investment going forward, particularly as privatization of State Owned Enterprises is expected to be completed by 2010. This should encourage joint ventures and foreign investment in previously non-accessible sectors. The impetus of the recent WTO membership is supported by the announcement of both the Common Investment Law and the Unified Enterprises Law in July 2006 which introduce a common legal framework for all types of enterprise and provide for equal treatment of all investors.

Some 70% of Vietnam’s population of approximately 84 million is below 35 years of age, there are minimal ethnic, religious or political divisions and there is a palpable energy to be felt in the major centers which is reminiscent of Hong Kong and Mainland China in the early days of their economic expansion. Over 106,000 SME’s have mushroomed in recent years, with many families involved in small retail businesses, and this entrepreneurial spirit is also very apparent in the real estate sector.

Prior to 1990, all land in Vietnam was owned by the State and there was virtually no real estate market as there were no laws to regulate the use and transfer of property in the private sector with housing being distributed by the State. However in 1986, the Government introduced the “doi moi” reforms which led to a slow movement towards a more open and market driven economy. The first land laws came into force between 1990 and 1998 when the concept of private “ownership” was recognized. Widespread speculation resulted and land prices soared, with a number of foreign investors undertaking large scale commercial and luxury residential projects on both Hanoi and Ho Chi Minh City. Between 1998 and 2004 revised land laws were decreed to curb speculation and with the onset of the Asian financial crisis many foreign invested projects collapsed, although the Vietnam economy itself did not suffer too severely. Small local developers emerged but no major projects were undertaken as there was little or no interest from overseas. In 2004 the new Land Law attracted increased foreign interest and enhanced real estate funding options. These, together with the improved economic conditions, increasing incomes and shortage of supply in all sectors, encouraged new foreign investment. Land use rights now have to be auctioned when the State sells land, improvements have developed in mortgage lending with 75% loans over 15 years now available, joint venture developers are permitted to build apartments for sale and compensation for losses due to redevelopment are now closer to market values meaning the site clearance is no longer such a long drawn out issue.

All land continues to be held by the State with land use rights (LUR) being sold in very much the same way they are in China. Vietnamese citizens can have effective “freehold ownership” in that there is no time limit on their LUR and can joint venture with foreign investors with the latter also being able to lease directly from the State or from local companies for development purposes. LUR owned by foreign companies are granted for 70 years in the case of infrastructure projects but limited to 50 years for other uses. LUR can be leased, mortgaged, exchanged, transferred or inherited although large scale projects still require the approval of the Prime Minister’s Office.

What is driving the new strong demand for real estate in Vietnam?

·Increased standard of living and rapid urbanization
·Current lack of supply
·Urban infrastructure development
·Increased availability of mortgages
·Growing remittances from over 3 million overseas Vietnamese
·Large young population looking to buy their own homes
·Developing real estate legal framework
·Strong growth in tourism

Where do the major opportunities lie?

The residential sector is very attractive as there is significant latent demand driven by the rising income of the burgeoning middle class. The GDP per capita in Ho Chi Minh City increased by 32% between 2000 and 2004, from US$1,365 to US$1,800 while the average across the country in 2005 was US$620. The young profile of the population means that many are at an age when they wish to marry and have their own home and it is estimated that there is a need for 60 million square meters of urban residential space – almost doubling the current stock. With prices ranging from US$900 per square meter upwards in the mass market and US$1,200 upwards in the luxury sector, there is still no shortage of purchasers.

The office market also offers opportunities in that there is a serious lack of quality accommodation in both Hanoi and Ho Chi Minh City, with both having occupancy rates of 95%. It is only recently that new project of over 10,000 square meters have commenced and the continuously rising rental have now reached the same levels as those seen in Shanghai (i.e. between US$30-35 per square meter exclusive of VAT). Some 540,000 square meters of new office space is required in HCMC by 2010 with the figure for Hanoi estimated at 150,000 square meters, assuming current growth in new businesses continues.

A nascent market for modern retail formats is now starting to emerge and the amount of retail space will need to expand by 5 times over the next 5 years to match stock to population ratios in other Asian cities. There is no real shopping centre in HCMC and only two department stores so that while some projects are under development the market is still wide open. The leisure and hotel markets are other areas of interest with Vietnam billed as the next Thailand – its 3,000 km of coastline is very suitable for resort and villa developments and tourist arrivals have increased 25% since 2004. Four and five star hotels are enjoying very high occupancy rates during peak periods and there are many opportunities for foreign operators to improve service and returns.

In the industrial sector, many of the industrial zones, particularly those close to HCMC, have limited supply of ready built factories available due to recent demand and international newcomers mostly have to build their own facilities so that new industrial parks could prove to be sound investments. There is also mileage in developing new townships and communities in areas surrounding existing urban areas in that “green field” development can be more straightforward and subject to fewer delays in the approval process.

So what are the challenges?

Vietnam is an emerging market and transparency is not yet all it might be. Politics still play a role in economic decisions and delays can arise for reasons which are difficult to understand. However, the new laws and their implementing regulations are improving matters and while projects may progress more slowly, if they are properly structured and funded and designed within the known planning parameters, they should eventually receive the licenses and permits required. In many cases it is an advantage to have a local partner who can steer the project through the various statutory and licensing processes and that choice of partner is, as in any emerging market, critical. Similarly, time and effort spent on diligence, or parting the curtains, and not necessarily accepting everything at face value, is time well spent.

Imperfect the market may be but there is a clear correlation between risk and reward and the ability of the economy to leapfrog many traditional stages of development means that it is already asserting itself as a significant player in the region and attracting investment accordingly.